Fixed and adjustable-rate mortgages

Fixed-rate mortgages carry an interest rate that does not change throughout the entire term of the loan. The most popular fixed-rate mortgage has a term of 30 years.

Adjustable-rate mortgages (ARMs) carry an interest rate that is fixed for only a portion of the term of loan. The period during which the rate is fixed can be as short as one month or as long as the first 10 years of a 30-year term. ARMs generally carry a lower rate of interest than fixed-rate mortgages. After the fixed period expires on an ARM, the interest rate will adjust once every six months or one year according to a formula. The formula takes an underlying index value and adds that value to a specified margin over the index in order to arrive at a new rate for the loan. ARMs carry periodic and lifetime "caps" that limit how high or low the interest rate can go during the adjustable period of the loan.

Fixed-rate mortgages work well for people who plan to stay in their home for many years. ARMs work well for people who will most likely move within a few years. If you plan to move within a few years of purchasing a home, it may not make sense to sign on for the higher rate of interest associated with a fixed rate loan. In addition, because they usually carry a lower interest rate, ARMs will offer a lower monthly payment. If you're having trouble qualifying for a purchase, an adjustable-rate mortgage may work well for you, since the smaller monthly payment will allow you to qualify for a larger loan. 

Interest-only and amortizing mortgages

Amortizing mortgages. With amortizing mortgages each monthly payment includes both principal and interest. Principal is the money you borrow from the lender. The lender requires that you repay its money according to an amortization schedule. The word amortization comes from the French word "mort" which means death or dying. Every time you make a mortgage payment some portion of the debt you owe the lender is "dying".

Interest is the price the lender is charging you for borrowing its money. Each mortgage payment on an amortizing loan includes some interest. The amortization schedule is set up so that during the early years of the loan your monthly mortgage payment consists mostly of interest. Towards the end of the loan most of your monthly payment is principal. Although the amount of interest and principal you pay changes every month, your mortgage payment will remain the same provided you have a loan with a fixed rate of interest.

Interest-only mortgages. Some loans come with the option to pay only the interest each month. Normally, mortgage payments are amortized, which means that they include both principal (the original amount borrowed) and interest. Interest-only payments on a loan will be significantly lower than amortized payments at the same rate of interest because they do not include principal repayment. Interest-only mortgages also offer flexibility: you can choose to pay the lender only the interest owed, or you can pay principal as well.  However, interest-only mortgages specify that you must begin repaying principal at some point during the life of the loan, usually after 5 or 10 years. (You cannot continue to make interest payments alone throughout the entire life of the loan.)

Loans by occupancy type

Lenders provide the best interest rates and loan terms for properties that will be owner-occupied. The reasoning is that you will do whatever is possible to make your mortgage payment on your home because if you don't, you may lose it. Lenders provide similar interest rates and terms if you buy a vacation (second) home. However, for non-owner-occupied (investment) properties, lenders generally require a larger down payment and higher rate of interest. Lenders perceive the risk to be higher for investment properties, since you are not at risk of losing your primary residence if you don't repay the loan.

Down payment options

Lenders prefer that you invest your money alongside theirs. If you don't contribute your own money toward the down payment, the lender becomes the only party at risk if you're unable to pay your mortgage. For this reason, your loan terms and interest rate will generally be more favorable when you make at least a 20% down payment.

If you make only a small down payment the lender perceives its risk as being higher and will ask to be compensated for this risk by charging a higher rate of interest, possibly offering more restrictive terms, and requiring mortgage insurance. Down payment options can be broken down as follows:

20% down payment. If you make a 20% down payment toward your purchase, the lender finances the remaining 80%. With a 20% down payment you'll get the best terms and interest rate on your loan for the purchase of a single-family home. It's also possible to make a 20% down payment for a condominium purchase you will be penalized -- the rate will be higher than for a single-family home. For either a single-family home or condominium a 40% down payment will give you an even better rate.

25% down payment. If you make only a 20% down payment for the purchase of a condominium your rate will be higher.  If you make a 25% down payment, your rate will be the same as for a single-family home loan. 

10% down payment. If you make a 10% down payment, the lender finances the remaining 90%. However, when the loan constitutes more than 80% of the value of the property, lenders require that you insure them against the possibility that you will be unable to make your loan payments. This insurance is called mortgage insurance. The cost of mortgage insurance varies depending on the loan amount size.  It usually adds $100-$400 to your monthly mortgage payment.

3.5% down payment (FHA). 3.5% is the smallest down payment option and is only offered under FHA loan guidelines. If you're only able to contribute something less than 10% of the purchase price, you're better making this downpayment and saving your money for closing costs and possible improvements to the property.

FHA loans are great for borrowers who are short on down payment funds.  However, they come with more restrictions than conventional loans (loans requiring at least 10% down).  If you're interested in exploring this option, let me know and we can discuss whether it's appropriate for your situation and the property you're interested in purchasing.

Gifts.  As long as you meet the minimum down payment rules outlined above, it is possible for someone to give you money for your down payment. Lenders require that you supply a “gift letter” showing the donor name and relationship to you (the donor should be a family member) and how much money will be provided. In addition, the gift letter must state that the donor is not requesting that you repay the gift.

When using a gift, lenders require that you, the borrower, contribute at least 5% toward the down payment. The rest of your down payment may come from gift funds. However, if the gift you're receiving is for 20% or more of the purchase price, you are not required to contribute any funds toward the down payment. (FHA loans are an exception -- they require that only 1% of the down payment funds come from you.)

Second Loans

Second loans can be useful if you need to borrow more than the conforming or agency jumbo loan limits.  They can help you bridge the gap between your down payment and your first loan.  For example, if you buy a home which costs $1 million and want to make a 20% down payment, you need to borrow $800,000.  To get the best rate you can limit your first loan amount to no more than $729,750, the agency jumbo maximum.  You could then get a second loan to make up the difference -- $70,250.  Similarly, if you need a loan amount just over the traditional conforming limit of $417,000 you could take a second loan to bridge the gap as long as you're still making at least a 20% down payment.

Fixed second loans are amortizing loans. That means each payment includes both principal (the original amount borrowed) and interest. As the name indicates, fixed second mortgages have an interest rate that is fixed for the entire term (usually 30 years). The principal repayment schedule is calculated as if it is spread out over 30 years. However, fixed seconds usually require a "balloon" payment after 15 years. The balloon payment covers all money not yet repaid after year 15. To avoid making a balloon payment you can pay off the mortgage before year 15 or refinance it into a new one before it's due.

Home equity lines of credit are interest-only, adjustable loans. The interest rate is usually based on some margin over the prime rate of interest. The prime rate is the rate the Federal Reserve charges member banks to borrow money in order to meet withdrawal demands. The interest rate on a home equity line of credit will change any time the prime rate does. Home equity lines of credit usually allow you to borrow money and make payments of interest for the first 10 years of the loan. After that, the lender requires that you begin repaying principal. One advantage of a line of credit is that even if you pay the lender back you still have the option to draw money on the line again in the future.

Second loans are fairly hard to come by in today's market.  As a result of the mortgage crisis, most lenders either stopped or severely curtailed their second loan programs.  The loans which are still available permit a maximum of 80% total financing.  In other words, it's no longer possible to get a second loan to finance over 80% of a property's value. 

Prepayment Penalties

Some loans come with prepayment penalties which specify that you will be assessed a penalty if you repay the loan within a specific period of time. Most prepayment penalties are in effect between one and five years. You may want to accept a prepayment penalty on your loan because lenders will usually give you a lower your rate of interest in exchange. You may also not have a choice. Some loan programs require prepayment penalties because the lender perceives it is taking on a higher level of risk. By requiring a prepayment penalty the lender can minimize its risk by discouraging loan repayment during the first few years of the loan's term. A typical prepayment penalty is either 20% of the loan's outstanding balance or six months of interest, whichever is less.

It is important to note that it still may be possible to repay a portion of your loan even if you have a prepayment penalty. Generally, you can repay up to 20% of your loan's balance each year without incurring a prepayment penalty.